Mr. Hedge Fund Goes to Washington

“This can’t be right. This is America. It’s like I took 80 percent of your house in the financial crisis because you couldn’t pay, and then you somehow crawled your way back, and instead of saying, ‘Wow, you made it!’ ‘I say, ‘Now I’m going to take 100 percent.’”

—Bruce Berkowitz, CEO of Fairholme Capital Management

Three days before Hensarling’s PATH Act passed the House Financial Services Committee, a $10 billion hedge fund called Perry Capital, which is run by former Goldman Sachs executive and Democratic power player Richard Perry, sued the U.S. government over its handling of the GSEs. The lawsuit was an outgrowth of Perry’s investment in Fannie and Freddie, which happened in late 2010, when Perry bought, for 3 cents a share, that supposedly worthless Fannie and Freddie junior preferred stock, the securities that had been originally sold right before conservatorship.

To understand why anyone would invest in Fannie or Freddie at that time—let alone later sue the U.S. government—you have to understand the unique and punitive nature of their bailout. A positive net worth helps the market have confidence in financial institutions like Fannie and Freddie, so they were required to draw money from Treasury to keep their net worth positive. But “net worth” is an accounting concept that factors in estimates of future losses as well as current losses. Fannie and Freddie were required to draw money based on estimates that they would lose billions in the future. These estimates would turn out to be far too high. In addition, while financial institutions in trouble never pay cash dividends, Fannie and Freddie were required to pay a 10 percent dividend back to Treasury on any money they took. This had some perverse consequences. Because the dividend payment further reduced their net worth, they also had to draw additional money from Treasury to fill the hole caused by the dividend payment. According to a FHFA official, around $45 billion of Fannie and Freddie’s $187 billion bailout consisted of draws that took money from Treasury only to round-trip it right back to Treasury as a dividend payment. (Other analysts think the figure is lower, around $30 billion.)“It was a complete payday lender situation,” says someone close to the situation. “It was like borrowing from a loan shark.”

Ultimately, Fannie Mae took $116.1 billion and Freddie Mac $71.3 billion from the U.S. Treasury, a total of $187.4 billion. One analysis done on behalf of a major investor shows that most of the losses were caused by non-cash charges such as provisions for loan losses—losses that never materialized. During the period in which the GSEs lost money, from 2007 to 2011, the provisions for losses exceeded the actual losses by $141.8 billion. Put another way, if Fannie and Freddie had only reported their cash losses, and had kept their deferred tax assets instead of writing them off, they would have lost $64.1 billion, according to this analysis. Considering the amount of equity they held heading into the crisis, their combined equity deficiency would have been only about $10 billion.

But because the GSEs had to pay the dividend on the full amount they drew, Tim Howard would later calculate that Fannie was obligated to make $11.6 billion in dividend payments for every year in the future—more than Fannie had earned in any single year in its history. “Seemingly it was a death sentence,” Howard wrote. In a speech in the fall of 2011, Ed DeMarco said Fannie and Freddie “will not be able to earn their way back to a condition that allows them to emerge from conservatorship. In any event, the model on which they were built is broken beyond repair.”

When almost everyone was gnashing his teeth about the apparently mounting losses at the GSEs, some investors began to do the math, and they found that Fannie and Freddie weren’t doing nearly as poorly as it seemed. One of the first people to call it publicly was an Australian hedge fund manager named John Hempton. In an August 2009 blog post, he noted that the actual cash losses Fannie and Freddie had reported to date were “simply not large enough to have caused problems.” After going through filings, he noted that the estimates of future losses were “extremely harsh.” Hempton would later call Fannie and Freddie’s post-bailout financial report the greatest accounting fraud he’d ever seen. He didn’t mean “fraud” in the usual sense of fraud, in which a company understates its losses, thereby making the financial picture look prettier. He thought Fannie and Freddie were overstating their losses, thereby making the financial picture look uglier. This was unique, even in the crisis. An analysis done by Fairholme shows that during and after the financial crisis, big banks like JPMorgan Chase and Wells Fargo reserved about the same amount that they eventually took in losses, whereas Fannie and Freddie’s provisions for potential losses were much higher than the loan losses they actually incurred.

Some investors also noticed that despite all the rhetoric about killing Fannie and Freddie, when the government put them into conservatorship, Jim Lockhart had said that the goal was to return Fannie and Freddie “to normal business operations” and that “both the preferred and common shareholders have an economic interest in the companies . . . and going forward there may be some value in that interest.”

Eventually, if the housing market began to recover, accounting laws would require that the estimated losses that had never materialized be reversed and booked as profits. The deferred tax assets would have to be reinstated, because after all, if the GSEs were profitable again, then the deferred tax assets would have value. The profits would be gigantic. Perry Capital and other major hedge funds began buying up the junior preferred shares, which were still priced near zero. Some of them, like Perry, were funds that had made fortunes betting against, or shorting, subprime mortgages in the run-up to the crisis, which was documented in the book The Greatest Trade Ever. Paulson & Co., run by John Paulson, who personally made almost $4 billion from shorting subprime securities, bought shares. So did a hedge fund called Claren Road that is majority owned by the Carlyle Group, the politically connected Washington, D.C.–based asset management firm.

For a long time, the investors thought Fannie and Freddie were like normal companies. Conservatorship wasn’t supposed to be forever. Fannie and Freddie required restructuring—they would need huge amounts of additional capital to get back in business, and the government would have to revise the terms of its senior preferred stock—but restructuring is what happens when companies run into trouble. “We are used to distressed financial companies,” one investor says. “We do not shut it down and vilify the management teams. We figure out what works, what is salvageable.” He points out that when General Motors declared bankruptcy, its plants didn’t all get shut down.

“We expected the political rhetoric,” says another investor. “We thought, ‘It’s easy for you to say you want to kill them, and that they are an endless black hole.’ But once they were profitable, we thought the rhetoric would change.”

What was going on inside of the Treasury at this time is now the subject of multiple lawsuits. But certainly, people at Treasury had heard the case for the GSEs’ return to profitability. On June 13, 2011, lawyers from the firm Skadden, Arps and representatives from the Blackstone Group, the sprawling investment corporation run by billionaire Stephen Schwarzman, which has a group that specializes in restructuring troubled companies, traveled from New York to see officials at Treasury to pitch the government on how best to deal with Fannie and Freddie. According to a presentation they gave, they told Treasury that Fannie and Freddie were showing “improved financial performance and stabilized loss reserves.” They urged the Treasury officials to allow Fannie and Freddie to build up fresh capital through their earnings—and to make sure that the investors were paid. As one slide read, “private capital will not make any substantial commitment to a solution in the absence of any likelihood of a meaningful return on equity capital.” The translation: Unless the investors got paid for what they owned already, they were certainly not going to contribute to the mortgage market any more of that private capital the government was saying it wanted.

After that, the hedge fund arm of Blackstone, which operates separately from the rest of the group but which had also come to believe that Fannie and Freddie would soon be very profitable, bought some of the outstanding preferred shares too.

There’s some evidence that by that time, people at Treasury did know that Fannie and Freddie would return to profitability—and they were worried about it. After all, amid the brewing anti–hedge fund sentiment in Washington, the last thing anyone wanted was to be accused of enabling a payday for wealthy investors from a taxpayer-funded bailout. In December 2010, Jeffrey Goldstein, then the undersecretary for domestic finance at Treasury, wrote an internal memo to Geithner discussing an option that would enable Treasury to “make clear the Administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from the GSEs in the future.”

Just as investors had predicted, Freddie posted a profit in the fourth quarter of 2011. The next quarter, Fannie did too. Trading in their outstanding securities went crazy. When the two companies reported earnings in August 2012, Fannie made $5 billion, while Freddie made $3 billion. Neither company required money from Treasury anymore.

The Third Amendment

Then, on August 17, 2012, a sleepy summer Friday, Treasury and the FHFA changed the rules of the game.

Going forward, instead of paying a 10 percent dividend, Fannie and Freddie would be required to send every penny they made to Treasury. If everything went to the government, then there was no value left for investors. Both the common and the preferred shares plunged in price. Fairholme Capital Management, which manages around $10 billion on behalf of some 180,000 individual investors and a few institutions, described it this way in its annual report: “The bureaucrats have illegally expropriated and de facto nationalized two of the most valuable companies in the world with apparent impunity.”

The government has a justification for what came to be known as the Third Amendment (because it was the third time the Treasury had amended the rules governing the bailout.) The Third Amendment was signed by both Tim Geithner and Ed DeMarco. Mario Ugoletti, a former Treasury official who joined DeMarco at FHFA in 2009, would later say in a legal filing that “institutional and Asian investors” in the GSEs’ securities were worried that there eventually wouldn’t be enough money on the Treasury lifeline given the perilous state of Fannie and Freddie’s finances and the huge dividend payments owed to Treasury. So it made sense to end the practice of round-tripping, and just have Fannie and Freddie pay whatever they made, thereby reassuring investors that they’d never run out of funding. (DeMarco won’t comment on the Third Amendment, but if he thought that a revitalized Fannie and Freddie would be the worst possible thing for taxpayers, then it’s easy to see why he might have endorsed it. Geithner declined to comment.)

It was at this point that Bruce Berkowitz, who runs Fairholme, decided to invest in Fannie and Freddie.

If Perry’s investment seemed contrarian, this was, on the face of it, flat-out crazy. But not to Berkowitz, who is what’s known as a value investor—someone who seeks out not the next hot technology investment, but rather troubled companies that might have redemption in their futures. He’d been analyzing an investment already. The securities, which had run up in price as hedge funds bought them, plunged to bargain-basement prices. And, he says now, “When I read it [the Third Amendment] I thought there was a typo. This can’t be right. This is America. It’s like I took 80 percent of your house in the financial crisis because you couldn’t pay, and then you somehow crawled your way back, and instead of saying, ‘Wow, you made it!’ I say, ‘Now I’m going to take 100 percent.’”

In Berkowitz’s view, the logic was just so obviously flawed: If the government wanted 100 percent of the GSEs, then it should have nationalized them, instead of leaving the preferred and common stock outstanding. Under the law governing conservatorship, the FHFA had a duty to “preserve and conserve” Fannie and Freddie’s assets, not just go along with what the Treasury wanted. And the notion that foreign investors were worried seems like an after-the-fact excuse, because in the investors’ eyes, it was obvious that Fannie and Freddie were about to become extremely profitable. (A former government official insists that it is “flat-out incorrect” to say that anyone in the government foresaw the coming tidal wave of profits.)

There are a lot of more nefarious theories as to what was really going on. Treasury was worried about Fannie and Freddie being profitable again, because no one wanted to read headlines about hedge funds making fortunes. And the losses helped cement the narrative that the GSE model was a failure, and that Fannie and Freddie must be abolished. “Fannie and Freddie got the concrete life preserver when they were holding the banks’ heads up over the water,” Tim Howard says. “After they dug themselves out of the hole, Treasury put them back in. That’s because they were supposed to be shut down before they became profitable again.”

The Piggy Bank

There’s also speculation about another factor. The Third Amendment came a year after the huge fight in Congress over raising the debt ceiling. Since that time, battles over spending have become commonplace. The profits generated by Fannie and Freddie, which go straight to Treasury, have at critical times helped buy breathing room, or as Treasury Secretary Jack Lew said in recent congressional testimony, “As a practical matter, it’s what has helped us to reduce our overall deficit.” One investor jokes bitterly that hedge funds can no longer claim the Greatest Trade Ever: Based on the amount the U.S. government has made from Fannie and Freddie, it’s the government that deserves that distinction.

Indeed, Fannie and Freddie’s contribution to the U.S. budget has not been small. The Congressional Budget Office has noted that the $83 billion decline in outlays between 2012 and 2013 “resulted primarily from transactions between the Treasury Department and Fannie Mae and Freddie Mac.” Thanks to the GSEs’ profits, federal spending was underreported by a combined $178 billion in 2013 and 2014, according to a paper by the Heritage Foundation. The authors noted that a new deal struck between Democrats and Republicans came right after Treasury reported the GSEs’ 2013 profits. “Undoubtedly, rosy reporting considering short-term improvements in federal spending and the deficit played a role in the decision to increase spending immediately for promised spending reductions in the future,” the authors wrote. Not incidentally, there is no accountability for how the profits from Fannie and Freddie are spent; and once the money is spent, it is gone and cannot be used to buffer any losses they might suffer again, or be used to capitalize a new housing finance system.

This is why Berkowitz complains that the government is using “two publicly traded, shareholder-owned companies as a piggy bank.” In 2011, before the Third Amendment, the government explicitly funded a continued cut in payroll taxes by having Fannie and Freddie raise their guarantee fees by 10 basis points, or one-tenth of 1 percent. In other words, by government decree, mortgage borrowers paid for the payroll-tax cut.

Suing the government isn’t an easy or cheap decision, and the investors initially believed that someone in the government would care about their rights, but Treasury had no interest in hearing from the aggrieved investors, they say. “We tried to compromise, but there was dead silence,” Berkowitz says. “The same bureaucrats who have repeatedly called for more private capital to support our housing-finance market view existing shareholders with outright contempt.” But these existing shareholders just happened to be some of the country’s wealthiest investors, and unlike most people, they can afford to fight. So Perry signed up Theodore Olson, who was the solicitor general in the Bush Administration and is now a partner at the Washington law firm Gibson Dunn, and sued the government. Fairholme was next to file. Eventually, about 20 lawsuits were filed.

Most plaintiffs agree that the most important issues are what they allege is the violation of the 2008 law governing conservatorship, which says that Fannie and Freddie are supposed to be put in a safe and sound condition, and the bailout’s third amendment, which they allege violates the Constitution’s Fifth Amendment: The government cannot confiscate private property without paying for it. In other words, this isn’t about the government’s actions in a time of crisis, but rather about the government’s actions after the crisis had passed. “Have you seen House of Cards?” Berkowitz asks, referring to the popular Netflix show that cynically depicts the rise of a powerfully corrupt president. “It’s real!” Many hedge funders invest in other places around the world, such as Argentina, where governments do things like seize private property with impunity. In 2012, Argentina nationalized assets belonging to a Spanish oil company called Repsol; in 2014, Argentina agreed to pay Repsol part of what it was owed in order to bring foreign investment back to the country. A joke goes: “What’s the difference between the GSEs in the United States and Repsol in Argentina?” The punchline: “Argentina settled.”

In Washington, there is a distinct lack of sympathy for the investors and for the argument about their private property rights. Berkowitz recalls complaining to one politically plugged-in person, only to be told to “grow up.” There are some in D.C. circles who believe the government only left Fannie and Freddie’s common and preferred shares in private hands because it had to do so to avoid putting their debt on the federal budget. Since everyone knew that this was a façade of convenience, the investors should have understood that what they view as their property always belonged to the government. Or as Geithner said in a deposition in an unrelated case, the U.S. government “effectively nationalized” Fannie and Freddie. Add to that the political hatred for the two companies. What makes sense using New York financial logic is borderline insane when you apply a Washington political calculus.

Those who have been around Fannie and Freddie for a long time think the investors were painfully naïve. How could they think this was just another distressed investment when Fannie and Freddie have always been treated differently from other companies? As a former Fannie executive puts it, “Any arrangement that leaves shareholders in place but doesn’t allow them to get any value seems like an un-American thing to do. But there are those who would argue that the GSEs are un-American to begin with.”

The highly charged, topsy-turvy world of Fannie and Freddie, where those who should be your friends might just be your foes, certainly has been a shock to the investors. One might expect that Republicans would be upset about the government nationalizing an industry, confiscating its profits, and using the money to help a Democratic administration improve its budget deficit. But that is not the case, because the hatred of Fannie and Freddie seems to trump all else. At a recent House Banking Committee event, the conservative economist Peter Wallison was asked if there was any good that could come out of Fannie and Freddie being released from conservatorship. “No,” he said. “I’m perfectly happy that government is taking all their profits, because it keeps them from gaining capital. If they had capital there would be tremendous pressure in Congress to release them.”

“In a normal world, Republicans would care about the rule of law,” says one investor. “But Republicans want to kill Fannie and Freddie, so they want to starve them of capital. Democrats want to keep the system as it is, where the GSEs have been de facto nationalized.” Keeping the hedge funds from getting paid crosses party lines.